United States: To Be Or Not To Be: Asian Hedge Funds Face U.S. Registration and Distribution Conundrum

While U.S.-focused hedge funds struggled for much of 2005, hedge funds focused on certain Asian strategies posted record performance numbers last year. Specifically, the rising tide in Japan, evidenced by the approximately 20% increase in the benchmark Nikkei 225 Index, produced returns in the 30% to 40% range by certain Japanese equity long-short hedge fund managers. With such a performance disparity to the U.S. markets, it was inevitable that U.S. institutional investors would flock to the region – and they have. It is estimated that as much as $20-$25 billion on an annualized basis is now flowing into local Japanese hedge funds; much of it from U.S. fund of funds, pension funds, and other institutional investors. Japanese and other Asian-based hedge fund managers understand that there is a renewed interest in Asia and have become more aggressive in their marketing efforts towards U.S.- based investors.

This cross-border allocation of capital has numerous implications under the securities laws and market practices of both countries, many of which are not readily apparent and only recently beginning to be understood by the industry and those who provide advice to it. As a result of the somewhat unusual structure of Japanese hedge funds that must be employed in order to avoid "permanent establishment" issues under the Japanese tax regime, Japanese hedge fund managers and U.S. institutional investors face many challenges. In order to avoid liability under U.S. securities law, Japanese hedge fund sponsors must carefully negotiate the U.S. broker dealer and investment advisory regulations.

As a result of the new U.S. hedge fund adviser registration rule, Rule 203(b)(3)-2 and its related amendments, under the U.S. Investment Advisers Act of 1940 (the "Advisers Act"), managers of Japanese hedge funds that have more than 14 U.S. investors on a "look through" basis must register with the U.S. Securities and Exchange Commission (the "SEC"). As a practical matter, this means that any Japanese hedge fund manager that accepts subscriptions from a U.S. fund of funds will need to register with the SEC.

Due to the arcane and often opaque tax rules in Japan, Japanese hedge funds are typically structured to have an investment manager located outside of Japan that executes the securities transactions on behalf of the fund, and what is referred to as the "Japanese sub-adviser" that is located in Japan and provides "investment advice" to the non-Japanese investment manager but which does not exercise investment discretion. Upon discrete inquiry, the SEC has advised that both of these entities must register as U.S. investment advisers because each entity provides an advisory function on behalf of the fund. If there is no U.S. place of business, each of these entities may rely on the "registration lite" regime available to non-U.S. investment advisers. The manner in which the relationship between the hedge fund and each of the non- Japanese investment manager and the Japanese sub-adviser is described in the offering materials may satisfy Japanese tax considerations, but as we shall see, this often convoluted and imprecise disclosure may have negative consequences when a Japanese hedge fund offers or sells securities to U.S. investors.

Under the "registration lite" regime, non-U.S. advisers are subject to the anti-fraud provisions of the Advisers Act with respect to all of their clients (including their non-U.S. clients), they must file Form ADV with the SEC and submit to the jurisdiction of the SEC, which includes being subject to SEC examinations, and maintain certain books and records in English. For certain of these investment advisers that maintain operations in lightly regulated jurisdictions, such as Singapore or the Cayman Islands, these considerations could very well seem onerous. For investment advisers that operate from Hong Kong, which maintains a rigorous "merit review" registration process for investment adviser applicants, the SEC rules present few, if any, additional burdens or considerations. It is unclear at this point how willing the Japanese Financial Services Authority will be to subject Japanese regulated investment advisers with no place of business in the U.S. to the jurisdiction of the SEC. Nonetheless, if both the investment manager and the Japanese sub-adviser register under the "registration lite" regime, the Advisers Act registration provisions would be met and the fund could accept subscriptions from more than 14 U.S. investors.

We have therefore determined that a typical Japanese hedge fund structure can satisfy U.S. investment adviser concerns, but what happens when an investment manager or the Japanese sub-adviser of a Japanese hedge fund promotes the hedge fund to potential U.S. investors?

Broad Definition of "Broker." The SEC has historically taken an expansive view regarding the activities that would subject an individual or an organization to the broker dealer registration requirements under the Securities Exchange Act of 1934 (the "1934 Act"). Simply put, any promotional, introductory, or marketing activity with respect to a security is a "brokerage activity" in the SEC’s view; and any person who engages in such activities may only do so after becoming an SEC registered broker dealer and, in most cases, a member of a self-regulatory organization, such as the National Association of Securities Dealers, Inc. (the "NASD"). The SEC has broad authority to seek injunctive relief, bring civil enforcement actions, or refer matters for criminal prosecution against any person alleged to be conducting brokerage activities without registration. Because the SEC’s view of what constitutes a brokerage activity is so broad, any unregistered individual or organization that is even peripherally involved with issuers of securities should conduct their activities in a manner that is consistent with SEC positions on such matters, or they should find an exemption from the definition of broker on which to rely.

The "Issuer’s Exemption." In the U.S., hedge funds are typically organized as limited partnerships or limited liability companies. The investment advisers of U.S. hedge fund are also usually organized as limited partnerships or limited liability companies, which serve as the general partner or managing member of the fund entity. Most U.S. hedge fund investment advisers appropriately rely on the "issuer’s exemption" in Rule 3a4- 1 under the 1934 Act to avoid registration as a broker dealer. Pursuant to Rule 3a4-1, an "associated person" of an issuer is not required to register as a broker dealer in order to engage in an offer or sale of the issuer's securities if certain conditions are met. Rule 3a4-1 was designed to permit principals of the issuer to sell their own securities without broker dealer registration. If an issuer employs an agent to sell its securities, that agent typically must register as a broker.

For hedge fund purposes, the term "associated person" of an issuer means any natural person who is a partner, officer, director, or employee of the issuer, a corporate general partner of a limited partnership that is the issuer; or a company or partnership that controls, is controlled by, or is under common control with the issuer. Additionally, the associated person must not be subject to a statutory disqualification, nor be compensated by the payment of commissions, directly or indirectly, based on the sale of the issuer's (fund) shares, or be an associated person of a broker dealer. This means that employees or owners of a general partner to a hedge fund that is organized as a limited partnership may rely on Rule 3a4-1 to engage in promotional and sales efforts on behalf of the hedge fund without registering as a broker dealer. Likewise, the managing member of a limited liability company the principals of which are also directors or officers of the general partner, would also be permitted to rely on the "issuer’s exemption."

The "Issuer’s Exemption" and Japanese Hedge Funds. But what about hedge funds that are not organized as limited partnerships? How does the exemption apply, if at all? Specifically, may a hedge fund organized as a Cayman Islands unit trust - the vehicle of choice for many Asian and specifically Japanese hedge fund investment managers and sub-advisers rely on Rule 3a4-1? Unfortunately, it appears unlikely that certain individuals affiliated with the investment manager or the Japanese sub-adviser of a fund organized as a unit trust may rely on Rule 3a4-1. Under Rule 3a4-1, an investment adviser that is a corporate general partner of a fund organized as a partnership, is a principal of the fund, and falls within the definition of an "associated person" of the fund.

Conversely, a hedge fund organized as a unit trust typically has only a contractual arrangement with its investment adviser, thereby creating an agency (and not a principal) relationship. The principal of a unit trust is the trustee of the fund, which typically also acts as the fund’s administrator, and which is unaffiliated with the investment manager and the Japanese sub-adviser. Agents of a fund are not "associated persons" under Rule 3a4-1 and therefore neither they nor their employees may promote or sell fund units within the borders of the U.S. or send promotional materials into the U.S. absent broker dealer registration. Such promotional and sales activities on behalf of a unit trust in the U.S. must be conducted either by the trustee, a very unlikely scenario, or through a U.S. registered broker dealer. The potential liabilities associated with acting as a trustee of a fund is just beginning to be understood by the large fund administrators who had recently accommodated their clients by taking on this added role. Quite recently, one very significant third party fund administrator has decided to exit the trustee business altogether.

The disparate treatment between limited partnerships (and limited liability companies) and unit trusts seems like a matter that the SEC should be able to remedy with the wave of its no-action wand. Indeed, the adopting release for Rule 3a4-1 states that exemptions from registration as a broker dealer for other types of entities, persons, and affiliates may be available on a case by case basis. The Office of Chief Counsel of the Division of Market Regulation (the "Division") at the SEC has indicated that the SEC staff will not provide industry interpretive guidance with respect to Rule 3a4-1, and would not view favorably a request for no-action relief from an investment manager or sub-adviser of a hedge fund organized as a unit trust. Additionally, the Division has taken the position that because Rule 3a4-1 is a safe harbor rule and cannot be interpreted beyond its content, activity that does not fall squarely within the four corners of the Rule would require registration of any investment manager or sub-adviser of a hedge fund organized as other than a limited partnership or a corporation.

"Common control" appears to be integral to the SEC in determining whether an entity will be an associated person of an issuer for purposes of the Rule. This presents an interesting dilemma for most Japanese hedge funds where the investment manager and the Japanese sub-adviser must go to great lengths to demonstrate that they do not control the fund. Therefore, it would appear that each of the investment manager and the Japanese sub-adviser would be required to argue inconsistent positions under U.S. and Japanese laws in order to both obtain relief under Rule 3a4-1 from the SEC, and avoid creating a permanent establishment in Japan, a precarious undertaking in this age of international information sharing. Accordingly, Japanese hedge fund investment manager and sub-advisers must find a suitable distribution alternative to reliance on Rule 3a4-1.

Investment managers and Japanese sub-advisers have only a few options at their disposal which would allow these sponsors to satisfy both U.S. securities regulators and the Japanese tax authorities when selling the hedge funds they advise to U.S. investors.

The Offshore Feeder. Japanese hedge fund sponsors could offer a separate feeder fund organized as a Cayman Island exempted company or Cayman Islands limited partnership with the principals of the investment manager or Japanese sub-advisers acting as either directors or general partners of the feeder fund. This could, however, create a control relationship between the investment manager or the Japanese sub-adviser and the fund that is sufficiently close for Japanese tax authorities to find that the fund or the Japanese sub-adviser has created a permanent establishment in Japan. The tax consequences would be unacceptable to fund investors and the two advisory entities and, therefore, this course of action should not be undertaken without advice from qualified Japanese tax counsel. Each of the investment manager and the Japanese sub-adviser would need to register under the "registration lite" regime to the extend the offshore feeder fund accepted subscriptions from more than 14 U.S. investors on a "look through" basis.

The Onshore Feeder. Japanese hedge fund sponsors may consider establishing a Delaware limited partnership with one of the Japanese sponsors acting as the general partner through a special purpose entity established in the U.S. for that purpose. The staff of the Division of Investment Management of the SEC has expressed the view that to the extent a U.S. domiciled entity receives a management fee or a performance fee (or carried interest) in the U.S., and other activities occur in the U.S., such as sending marketing materials into the U.S., full advisory registration would be required. This position clarifies and narrows the SEC staff view expressed in the December 8, 2005 no-action letter to the American Bar Association, Subcommittee on Private Investment Entities. In that guidance to the hedge fund industry, the SEC staff stated that if a special purpose vehicle ("SPV") were established for the purposes of acting as a general partner of an offshore fund, the SPV would not be required to register if all of the "associated persons" of the SPV were also "associated persons" of the entity that acted as the registered investment adviser to the offshore fund. No doubt readers had hoped that the SEC letter could also be construed to cover U.S. based SPVs with no substantial U.S. operations, however, this appears not to be the case.

Most Japanese and non-U.S. advisory entities that do not otherwise have a place of business in the U.S., would find the additional burdens of full Advisers Act registration unacceptable. Again, additional SEC oversight and the application of the Advisers Act anti-fraud rules would require inconsistent disclosures between what U.S. investors receive and what is provided to non-U.S. investors in order to satisfy Japanese tax considerations. The U.S.-based entity established to act as the general partner of the onshore feeder fund would also become a U.S. taxpayer and, although the U.S. tax liability can be minimized to a substantial degree through cost plus pricing, this would bring the U.S. based entity and its non-U.S. affiliates within the jurisdiction of the IRS, something that most non-U.S. asset managers seek actively to avoid.

Cash Solicitation Rule. The investment manager and Japanese sub-adviser could enter into a cash solicitation agreement pursuant to Rule 206(4)-3 under the Advisers Act. Pursuant to this rule, an investment adviser is permitted to pay a cash fee to a third party for promotional services with respect to the investment advisory services of the investment manager and sub-adviser. The advisory services of both the investment manager and the Japanese sub-adviser are being promoted, both parties would be required to enter into the cash solicitation agreement and any promotional materials would need to adequately explain the relationship of the parties to the fund. However, because the Japanese sub-adviser must actively disclaim in the offering documents any ability to control the fund, there remains a question with respect to whether such offering documents would satisfy the anti-fraud provisions of the Advisers Act. There is a further question as to whether the cash solicitation rule can be properly used by solicitors on behalf of investment advisers of hedge the funds to promote the fund itself. The better view is that any solicitor of a hedge fund adviser that is not also a registered broker dealer may only promote the advisory services of the investment manager to prospective clients and may not refer to specific funds or investment products in their marketing materials and activities.

For Japanese hedge fund managers and advisers, additional explanatory information would need to be developed that adequately explains the Japanese structure to U.S. investors in order for a solicitor and the advisers to meet their fiduciary duties under the Advisers Act. These limitations on the use of the cash solicitation rule could severely limit its effectiveness for providing information to prospective U.S. investors.

Brokerage Placement Agreement. Another alternative for Japanese hedge fund sponsors would be to enter into a placement agency agreement with a properly registered U.S. broker dealer. This may be the best solution as it is the type of arrangement clearly contemplated by U.S. securities laws; however, it also, is not without its concerns and potential liabilities.

Broker dealers must perform enough due diligence on any issuer whose securities it sells to be satisfied that it can make a suitability determination on behalf of the broker’s customer. A broker may use offering materials prepared by the issuer, but the broker may have liability for omitted, false, or misleading information in such materials, in spite of any indemnities it may have secured from the Japanese fund sponsor. At a minimum, the broker would need to supplement the fund offering documents with an adequate explanation of the relationship between and among the fund, the trustee, the offshore investment manager, and the Japanese sub-adviser. Furthermore, the NASD takes the position that related performance, i.e., performance of the portfolio manager with respect to a different investment vehicle, may not be used in offering materials for funds that are exempt from registration pursuant to Section 3(c)(1) of the Investment Company Act of 1940.

Additionally, the broker would normally enter into the placement agreement with the sponsor of the fund; however, in the case of funds organized as unit trusts, it is the trustee which has the legal authority to bind the fund. The trustee may be reluctant to provide the standard representations, warranties, and indemnifications because the true role of the trustee is that of third party administrator, not a sponsor that is willing to take on issuer’s risk. It is likely, however, that such representations, warranties, and indemnifications can be obtained from either the investment manager or the Japanese sub-adviser (or both) in a multi-party placement agreement or in a side agreement.

The investment manager and the Japanese sub-adviser also have concerns when entering into a placement agency agreement with a U.S. broker. Most notably, these fund sponsors may find themselves drawn into regulatory actions and civil lawsuits in a U.S. jurisdiction based on inflated, misleading, or false representations a broker may have made about the fund and the sponsors without the knowledge of the Japanese fund sponsors. It would be an expensive undertaking to defend any such action and to enforce indemnification rights against the broker if the choice of law in the placement agency agreement is a U.S. jurisdiction.

The rapid deployment of capital across borders is inevitable in our globally connected world; however, the investment structures used by money managers are often imperfect solutions that are cobbled together in an attempt to meet a combination of competing jurisdictional concerns. When Japanese money managers are outpacing other markets, the potential liabilities that these imperfect solutions create may seem like a distant improbability. But when the music stops and it always does, investors, distributors, and regulators alike have shown a great capacity to use any legal argument available to deflect liability, seek recovery, or bring enforcement actions. Accordingly, Japanese fund sponsors should structure their products, and the U.S. investment community should make their investment decisions within the laws that govern their respective activities.

Pillsbury Winthrop Shaw Pittman LLP represents hedge fund sponsors and advisers, prime brokers, and administrators through its 16 offices, located in global centers for capital markets, finance, energy, and technology.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.